- The financial statements are the cap stone
of a careful bookkeeping process.
- The key to properly recording a transaction
is remembering that the accounting equation,
assets equal liabilities plus equity,
must always be maintained.
- To illustrate the process of transaction analysis,
we use a hypothetical transactions for Hannah Market.
A small retail business.
- [Man With Glasses] During the year,
Hannah entered into the following transactions.
- [Man Without Glasses] One,
invested $700,000 of her own cash in the business.
- [Man With Glasses] Two,
borrowed $300,000 cash from the bank.
- [Man Without Glasses] Three,
purchased land, a building, and equipment,
for a total of $2 million.
Hannah paid $100,000 down in cash.
And the remaining $1.9 million
is financed with a mortgage.
- [Man With Glasses] Four,
purchased inventory items for resale,
for a total of $1,300,000.
The entire amount was put on suppliers accounts.
So no cash was paid at the time of purchase.
- [Man Without Glasses] Five,
sold inventory costing $800,000
to retail customers, for $1.1 million.
The customers paid $200,000 in cash
and the remaining $900,000 was put on
the customers accounts.
- [Man With Glasses] Six,
paid employees a total of $170,000 cash for wadges.
- The impact of each of these events
on Hannah's balance sheet and income statement
can be illustrated in a simple spread sheet.
- [Man With Glasses] One, as a result of Hannah's
$700,000 investment, the business now has
an increased amount of the asset cash.
Hannah's having invested the cash
should be reflected in an increase
in the amount reported as Paid in Capital.
An important equity category.
- [Man Without Glasses] Two, the increase
of $300,000 in the asset cash is paired
with an increase in the liability Bank Loan Payable.
- [Man With Glasses] Three, the asset cash
is reduced because of the $100,000 down payment.
We also note that a mortgage was created
as part of this transaction.
So we must record a liability Mortgage Payable
in the amount of $1,900,000.
- [Man Without Glasses] Four,
the inventory account is increased
by $1.3 million.
Also, because the inventory was purchased
entirely on account, the amount of Accounts Payable
has also increased by $1.3 million.
- [Man With Glasses] Five, as the result
of these customer sales, Hannah has added
to two asset accounts an increase in cash
of $200,000, and an increase in the asset
Accounts Receivable of $900,000.
When assets are generated
in the corse of doing business,
their source is recorded as revenue.
In this case, the account Sales Revenue
is increased by $1,100,000.
The Sales Revenue account is a sub category
of Retained Earnings, and represents an increase
in the equity of the business that's occurred
because of conducting business operations.
- [Man Without Glasses] In exchange
for the cash in Accounts Receivable,
Hannah gave up inventory, costing $800,000.
This is reflected by reducing the asset inventory
by $800,000.
This asset was consumed in the course
of business operations.
So, it is reflected as the expense cost of goods sold.
The $800,000 amount under Cost of Goods Sold,
is shown as a subtraction,
because it represents a reduction in equity.
- [Man With Glasses] As with the Sales Revenue account,
the Cost of Goods Sold expense account
is a sub category of Retained Earnings.
Now, when put together, the $1,100,000 equity increase
recorded as sales revenue.
And the $800,000 equity decrease recorded
as Cost of Goods Sold, means that operating
transactions increase the equity of the business
by $300,000.
The $1,100,000 revenue, minus the $800,000 expense.
- [Man Without Glasses] Six, Hannah paid her employees
$170,000 in wadges during the year.
This amount is reported as Wadges Expense.
As with the other expenses, Wage Expense
is a sub category of Retained Earnings
and reflects a decrease in equity.
Because resources were consumed
in the course of doing business.
- [Man With Glasses] Now, look at the spreadsheet.
You can see that for each transaction
we have made sure that assets equal liabilities
plus equity.
- [Man Without Glasses] And the end result
of this transaction analysis is the set
of account balances at the end of the year.
You can see these in the bottom row of the spread sheet.
- The purpose of the accounting process
is to create the financial statements,
which can then be used in making business decisions.